Short Selling or Short Trading

By Barry Burns

If you have reasons to believe that a market is going to go down, you can make money by short selling that market. Short selling (also known as going short or shorting the market) means that you’re selling the market first and then attempting to buy it later at a lower price.

It’s exactly the same principle of “buy low, sell high,” just in the reverse order — you sell high and then buy low.

[Credit: Figure by Barry Burns]
Credit: Figure by Barry Burns

You may be wondering, how can you sell a stock before you buy it? It’s actually not as difficult as it seems. To sell a stock that you don’t own, for example, you must first borrow it. Your broker facilitates this process and may let you borrow a stock owned by another trader or, less frequently, owned by the broker himself.

When you’re ready to exit your short position, you cover the position by buying back the stock you had shorted. In other words, selling before you buy really means you’re borrowing the stock before you short sell it.

This discussion is meant to be a simple introduction, not an exhaustive education to fully prepare you for shorting the market. Before shorting the market, talk to your broker about the risks and rules of short selling and educate yourself on all the details. Also be aware that the rules for shorting stocks may be different for shorting futures, spot forex, or other markets. Talk to your broker for details.

What makes short trading so exciting

Selling first and then buying later (hopefully at a lower price) has several advantages, including the following:

  • Markets tend to go down faster than they go up. This is because fear is a stronger emotion than greed. When people feel fear, they tend to exit their long positions quickly and massively. Markets can go into a free fall, and therefore it’s generally possible to make money faster by short selling than by buying, at least for brief periods of time.

  • By being flexible enough to short sell, you open up your ability to make money in various market conditions. When you’re comfortable going short, you provide yourself more opportunities to make money.

  • Shorting options can provide a hedge against your long positions.

    • Options are contracts that give the owner the right, but not the obligation, to buy or sell a stock at a given price before a certain time. They’re much less expensive than buying the stock itself and, therefore, can act as a type of insurance policy against a stock position.

      Taking a short position on a stock with an option would actually involve buying a put option. That can seem a bit confusing because you have short exposure to the stock as the value of the put option increases as the stock price moves lower.

      The benefit is that you pay a small premium, which can be thought of as a deposit that allows you to sell the stock at a higher price if the stock moves down.

    • Hedging is like buying insurance. It’s taking a trade that helps to offset losses you may take on a primary position.

The challenges of shorting the market

Like most things in the market, and in life, there are two sides to a coin. If you decide to incorporate short selling into your personal trading, it’s important to be fully educated about all the implications.

Short selling also has several disadvantages you should seriously consider:

  • It may feel unnatural, and you may struggle wrapping your head around the concept. It may be psychologically challenging and feel uncomfortable to you.

  • Going short is more expensive than going long. When you short a stock, you’re borrowing the stock and have to pay a fee, though nominal, for doing so.

  • Theoretically, short selling has unlimited risk. If the market goes against you (by going up), there’s no ceiling to how high the price can go.

  • It may feel unpatriotic to take a position against a business and/or the economy succeeding.

  • Not all stocks are available for shorting, and some of those that are available aren’t always available. This reduces the universe of stocks available for you to trade.

  • Short selling must be done in a margin account. It’s up to you to decide whether you’re comfortable trading with borrowed money.

  • If you’re short a stock when the company pays dividends, you’ll owe the dividend and it will be withdrawn from your account. Remember, when you short a stock, you don’t own it. You’re borrowing it from your broker who still owns it, so he will want the dividend if you’re holding the short position when the company issues dividends.

  • If a company spins off part of its operations, creating two companies, you could find yourself with a short position in both companies. That could be a problem if you’re not bearish on both companies.